The Fallacy of Structuring the Tax System on "the Rich"

Over the 2003-2008 period, as the country enjoyed an economic boom, state legislators allowed themselves to think the bubble would never burst. As a result, in many places, increasing prosperity lead to increased tax revenue and an increased desire to fund new programs with tax revenues of "the rich." Robert Frank, senior writer of the Wall Street Journal, chronicles this and points out how state legislators ignored predictions that they wouldn't be able to finance their schemes forever.

New York, New Jersey, Connecticut and Illinois—states that are the most heavily reliant on the taxes of the wealthy—are now among those with the biggest budget holes. A large population of rich residents was a blessing during the boom, showering states with billions in tax revenue. But it became a curse as their incomes collapsed with financial markets.

Arriving at a time of greatly increased public spending, this reversal highlights the dependence of the states on the outsize incomes of the wealthy. The result for state finances and budgets has been extreme volatility.

In New York before the recession, the top 1% of earners, who made more than $580,000 a year, paid 41% of the state's income taxes in 2007, up from 25% in 1994, according to state tax data. The top 1% of taxpayers paid 40% or more of state income taxes in New Jersey and Connecticut. In Illinois, which has a flat income-tax rate of 5%, the top 15% paid more than half the state's income taxes.

There are two responses for this. One is that the tax system should be structured so as to not rely on taxes that can be highly volatile (paid, as the article notes, by wealthy financial professionals). The other is that state legislators would be wise not to imagine that times of increased prosperity would last forever.

It would be wise to consider both of these solutions. The problem is that government officials can scarcely keep their hands off of newfound tax revenue, even when the prudent thing to do is stash it away for a rainy day.